The first school of thought, broadly that of the United States’ Republican Party, was that financial regulation was bad because all regulation was bad. The second, broadly that of the Democratic Party, was somewhat more complicated... Depression-era restrictions on risk seemed less urgent, given the US Federal Reserve’s proven ability to build firewalls between financial distress and aggregate demand. New ways to borrow and to spread risk seemed to have little downside. More competition for investment-banking oligarchs from commercial bankers and insurance companies with deep pockets seemed likely to reduce the investment banking industry’s unconscionable profits.

It seemed worth trying. It wasn’t.

Analytically, we are still picking through the wreckage of this experiment. ... Moreover, how to restructure the financial system remains unclear. ... And central banks’ failure to regard their primary job to be the stabilization of nominal income – their failure not only to be good Keynesians, but even good monetarists – raises the question of whether central banking itself needs drastic reform. ...

It may even be the case that we ought to return to the much more tightly regulated financial system of the first post-World War II generation. That system served the industrial core well, at least as far as we can tell from the macroeconomic aggregates. We know for certain that our more recent system has not.

Transcripts: There are a lot of folks out there who are still struggling with the effects of the recession. Many people are still looking for work or looking for a job that pays more. ...

But there are ... steps that we can take right now that would help...

Of course, one of the most important and urgent things we can do for the economy is something that both parties are working on right now, and that's reducing our nation's deficit...

No. No. No. No. No. No. NO. NO!!!!!!!!!

Absolutely the last thing, the last thing, the country needs is to cut federal spending or raise taxes in fiscal 2011, 2012, and it is now looking like fiscal 2013 as well.

Absolutely the last thing the country needs.

It gets worse. Obama:

[B]ecause of the work that's been done, I think we can actually bridge our differences. ... Nobody wants to put the creditworthiness of the United States in jeopardy. Nobody wants to see the United States default. ...

Does Obama read? There are some people who are looking forward to a default. And some of them are in the Republican legislative caucus--or so John Bresnehan and Jake Sherman claim:

"Who has egg on their face if there is a sovereign debt crisis, House Republicans or the president?" said another senior GOP lawmaker.

We have Republicans threatening to default on the debt and blow up the economy if they aren't allowed to put the economy at risk in another way -- through immediate deficit reduction -- and a president selling the demands from the other side as a jobs package. To make it worse, some Republicans seem eager for default to happen based upon the false belief that they'll somehow gain political advantage for wrecking the economy. No wonder the economic outlook is so grim.

With the economy struggling to get back on its feet, "Absolutely the last thing, the last thing" we should be doing right now is making threats or enacting policies that increase the risks of an economic setback. I think it's important to realize that the threat to default on the debt puts the economy at risk even if it is never acted upon, especially as the critical date to lift the debt ceiling draws closer. Republicans aren't just threatening to put the economy at risk in the future if they don't get their way, they are already doing so. If this continues there will likely come a point when markets get the jitters, and if that happens, watch out.

It is not the content or format that worries me. And, to be sure, the magnitude of the labor market damage wrought by the recession weighs heavily on my mind. Moreover, the length of time to recovery seems immense. And, on top of both of these, we effectively reduce our expectations of "recovery" with this chart - recovery should be about capturing the previous trend, not the previous peak.

Despite all this, it has always seemed to me that I was missing some even darker point. I think I finally identified that issue. Consider that the US economy remains about 7 million jobs shy of the previous peak of nonfarm payrolls. At 200k jobs a month - a seemingly optimistic forecast at this point - we regain the peak in about 35 months. We are already (believe it or not) 23 months into the expansion, which means that we recover the jobs lost in this cycle after a 57 month expansion.

If this expansion is typical, then we can expect just 2 months of job growth beyond the previous peak before the next recession hits.

Now suppose that job growth limps along at a monthly average of 150k a month. Then we are 46 months away from the payroll peak, or an expansion time of 69 months. Ten months shorter than the post-WWII average. In other words, even without resorting to an immediate double-dip scenario, we could very well be in recession prior to regaining the jobs peak.

Perhaps we should take some comfort in the fact that the average of the past three expansions is 95 months - which provides some room to grow jobs beyond the peak, but not much in historical perspective. Moreover, given the likelihood that the Fed begins a tightening cycle well before the payroll peak is in sight, and that fiscal policy looks poised to turn contractionary very soon, I have trouble thinking this recovery will be more like the past three (one of which included massive technological change) than the entire post-WWII average. That said, hope springs eternal.

The very real possibility that we will slip into recession prior to regaining the previous jobs peak casts the current situation in an even darker light than that of Federal Reserve Governor Sarah Raskin. Not only is the depth and duration of the unemployment crisis immense, but so too are the long-term consequences. The failure to design a coordinated package of monetary and fiscal policy to engineer a V-shaped employment recovery looks increasingly like a massive lost opportunity. And with that opportunity now lost, a return to even something sort of like the pre-recession jobs trend seems essentially impossible.

Monetary and fiscal policies cannot be expected to turn this situation around. The US Federal Reserve will maintain its policy of keeping the overnight interest rate at near zero; but, given a fear of asset-price bubbles, it will not reverse its decision to end its policy of buying Treasury bonds – so-called “quantitative easing” – at the end of June.

Moreover, fiscal policy will actually be contractionary in the months ahead. The fiscal-stimulus program enacted in 2009 is coming to an end, with stimulus spending declining from $400 billion in 2010 to only $137 billion this year. And negotiations are under way to cut spending more and raise taxes in order to reduce further the fiscal deficits projected for 2011 and later years.

So the near-term outlook for the US economy is weak at best. Fundamental policy changes will probably have to wait until after the presidential and congressional elections in November 2012.

Sarah Raskin is also worried, and seems to be one of the few Federal Reserve Board willing to "underscore" the employment part of the dual mandate (though I think Feldstein's right about further easing, that won't happen unless the outlook darkens considerably, and even then there's no certainty the Fed would take action):

In a speech to the New America Foundation, Raskin said the jobs market is actually in worse shape than what’s indicated by the headline 9.1% unemployment rate. ...Raskin told the audience “we should pause to underscore the promotion-of-maximum-employment imperative of the Federal Reserve’s dual mandate.” ...

Though statistics show that about 13.9 million Americans were out of work in May, an additional 8.5 million workers had to settle for part-time jobs or were forced to cut back on their work hours, Raskin said.

“It is necessary for the strength of our nation’s recovery that low- and moderate-income Americans be able to more fully participate in the economy,” the Fed official said. ...

I'm running a bit late so I don't have time to say as much as I'd like about this, but I don't like this advice at all (I've advocated, for example, proposing job creation policies very publicly, and then forcing Republicans to vote them down):

Obama needs to create jobs, not fight for them, by Ezra Klein: Ron Klain, former chief of staff to both Al Gore and Joe Biden, thinks President Obama needs to make more of a show of fighting for job-creating policies. “The greatest risk to the president will be if the American people believe the administration isn’t trying hard enough to tackle the jobs problem,” he writes. “That is why it is imperative for the administration to do more — proposing new ideas, initiatives and job-creation programs — and without delay. It may not succeed, but it must get ‘caught trying’ to do more to spur job creation.”

This advice appeals to me. It’s what I’d like to see happen. But I also think it’s wrong, and if I were advising President Obama, I’d advise him not to take it.

Let’s agree that what matters isn’t how many jobs you “get caught trying” to create, but how many jobs you actually create. There’s virtually no evidence that if Obama makes more speeches on jobs, his poll numbers will go up or the labor market will improve. There’s lots of evidence that if he passes policies that create more jobs, his poll numbers will go up and the labor market will improve. The question, then, isn’t how Obama can get “caught trying.” It’s how — or whether — he can succeed.

When presidents take a strong stand for or against policies, they polarize the policies. Under unified control of government — particularly under unified control of government with a filibuster-proof majority — that can make the policies easier to pass, as it consolidates party support. Under divided control of government, it makes them harder to pass, as it creates or hardens minority-party opposition.

A lot of observers wondered why the Obama administration didn’t push a payroll-tax cut in the 2010 elections. The reason, insiders said, was simple, if frustrating: If they did that, the Republican Party would publicly oppose it and they wouldn’t be able to pass it after the election. By staying quiet on the payroll-tax cut, they made it possible for Republicans to support it as part of the 2010 tax deal.

Recently, the Obama administration has been pushing an expansion of the payroll-tax cut. They want to extend it to employers, not just employees. But they’ve been more public about it. And sure enough, the GOP is suddenly finding itself opposed to a tax cut on business — man, polarization is a powerful force — and gripped by a sudden and, one imagines, soon-to-be-abandoned belief that tax cuts should be paid for.

All of which suggests that if any further jobs measures are going to pass, they’re going to have to start in backroom negotiations and only go public as part of a deal. Taking them public first in the hopes that you can then get them as part of backroom negotiations won’t work. So though I agree with Klain that the right political move for Obama is to push harder on jobs, if I were advising the president, I’d tell him to keep any policies that his legislative team thinks could actually pass out of his speeches. Because the right politics, in the end, won’t do him much good in November. The right jobs numbers will.

Some very quick thoughts:

1. This is not a one-shot game. You have to make the Republicans pay in terms of eroded public support before they will agree to cooperate at all. Yes, they might walk away, and that might hurt in the short-run, but if they are forced to pay a large cost in terms of public support then next time things will be different. The president in particular has not played a long-run strategy, the Republicans have, and the results reflect this.

2. "Let’s agree that what matters isn’t how many jobs you “get caught trying” to create." Why should I agree to take as given the point being debated here? We haven't been in this situation before, so past evidence isn't all that relevant. When we need jobs as bad as we do right now, making it clear the other side is standing in the way of that goal, and fighting for the policies you'd like to enact has more value than it did in the past.

3. Yes, it might cause Republicans to leave the negotiating table, but that's where the lack of public rhetoric really hurts. That's where Republicans must be made to pay for their behavior in the eyes of the public. Otherwise they will control the negotiations as they do now. The payroll tax, for example, was not the first choice of Democrats, it was chosen because of fear Republicans would walk away from any other proposal. Their public rhetoric had already boxed Democrats in and now Democrats are supposed to be afraid of trying to punch through that box in public. To me, this is about leaders and followers, and the administration is not the one leading policy right now.

4. The other side is not shy about going public, and that was also true when they controlled the White House. If this advice is correct, why didn't it hurt Republicans when they were in power?

5. Yes, jobs at election time would be best. But if the other side is pushing policies that work against that goal so that it is unlikely to be attained, I can't see how making that clear to the public would hurt.

[Again, I wrote this in a rush and am out of time. I'm sure I've left things out, the arguments aren't as clean as I'd like, etc., etc. -- mostly just putting this up for comments. Hopefully all of you can take it a bit further.]

It is probably best to accept that commodity prices will be volatile, and to create ways to limit the adverse economic effects – for example, financial instruments that allow hedging of the terms of trade. ...

But the ... policy that Sarkozy evidently has in mind is to confront speculators, who are perceived as destabilizing agricultural commodity markets. ...

But speculation is not necessarily destabilizing. Sarkozy is right that leverage is not necessarily good just because the free market allows it, and that speculators occasionally act in a destabilizing way. But speculators more often act as detectors of changes in economic fundamentals, or provide the signals that smooth transitory fluctuations. In other words, they often are a stabilizing force.

The French have not yet been able to obtain agreement from the other G-20 members on measures aimed at regulating commodity speculators, such as limits on the size of their investment positions. I hope it stays that way. Shooting the messenger is no way to respond to the message.

[The liberal] storyline gets one thing right: Government policy did have a lot to do with the decline of unions. But it wasn’t labor law that mattered. In a study of the decline of unions between 1973 and 1988, economist Henry Farber and sociologist Bruce Western found that the chief reason was that nonunionized companies grew faster than unionized ones. Employment at unionized companies dropped by 2.9 percent per year while employment at nonunionized companies rose by 2.8 percent a year. Another paper by the same authors confirms that the union elections overseen by the NLRB were a sideshow: If the NLRB had held no unionization elections since 1972, the percentage of Americans in unions would have dropped by only an additional 1.7 percent. … Government abetted the decline by encouraging competition among companies:

This is a reasonable summation of their findings, although Bruce Western, in a recent paper with Jake Rosenfeld appears to have changed his mind in the intervening years, noting that “an influx of corporate donations influenced policymakers to oppose pro-union reform of labor law in the 1970s” and that “[p]olitical defeats in the 1970s and 1980s yielded an ‘enervated’ labor law that enabled employers to block organizing campaigns and weaken existing unions.” Perhaps more to the point, Western and Rosenfeld provide substantial supporting evidence for the ‘immiseration of the middle class’ thesis that Ponnuru is seeking to disprove. ...

Nor is inequality, as Ponnuru seems to suggest, the product of more money going to those with higher skills. Western and Rosenfeld’s figures suggest that the decline of unions has been just as important a factor as education in explaining the rise of inequality among men. ...

In short, there is good prima facie support for the claim that deunionization has hurt the middle class by contributing to a particularly top-heavy form of increased income inequality, from an author whom Ponnuru cites and presumably takes seriously. Very likely he wasn’t aware of this recent work. ...

Bumblebees "make a clear trade-off between minimizing travel distance and prioritizing high rewards":

How bumblebees tackle the traveling salesman problem, EurekAlert: It is a mathematical puzzle which has vexed academics and travelling salesmen alike, but new research from Queen Mary, University of London's School of Biological and Chemical Sciences, reveals how bumblebees effectively plan their route between the most rewarding flowers while travelling the shortest distances.

The research, led by Dr Mathieu Lihoreau and published in the British Ecological Society's Functional Ecology, explored the movement of bumblebees, Bombus terrestris, as they collected nectar from five artificial flowers varying in reward value.

"Animals which forage on resources that are fixed in space and replenish over time, such as flowers which refill with nectar, often visit these resources in repeatable sequences called trap-lines," said Dr Lihoreau, "While trap-lining is a common foraging strategy found in bees, birds and primates we still know very little about how animals attempt to optimize the routes they travel."

Research into optimizing routes based on distance and the size of potential rewards is reminiscent of the well known Travelling Salesman problem in mathematics, which was first formulated in 1930, but remains one of the most intensively studied problems in optimization.

"The Travelling Salesman must find the shortest route that allows him to visit all locations on his route," explained co-author Dr Nigel Raine, "Computers solve it by comparing the length of all possible routes and choosing the shortest. However, bees solve simple versions of it without computer assistance using a brain the size of grass seed."

The team set up a bee nest-box, marking each bumblebee with numbered tags to follow their behavior when allowed to visit five artificial flowers which were arranged in a regular pentagon.

"When the flowers all contain the same amount of nectar bees learned to fly the shortest route to visit them all," said Dr Lihoreau. "However, by making one flower much more rewarding than the rest we forced the bees to decide between following the shortest route or visiting the most rewarding flower first."

In a feat of spatial judgment the bees decided that if visiting the high reward flower added only a small increase in travel distance, they switched to visiting it first. However, when visiting the high reward added a substantial increase in travel distance they did not visit it first.

The results revealed a trade-off between either prioritizing visits to high reward flowers or flying the shortest possible route. Individual bees attempted to optimize both travel distance and nectar intake as they gained experience of the flowers.

"We have demonstrated that bumblebees make a clear trade-off between minimizing travel distance and prioritizing high rewards when considering routes with multiple locations," concluded co-author Professor Lars Chittka. "These results provide the first evidence that animals use a combined memory of both the location and profitability of locations when making complex routing decisions, giving us a new insight into the spatial strategies of trap-lining animals."

Bruce Bartlett talks about who does and doesn't pay federal taxes, and notes that "the growth of the non-income-taxpaying population is largely a result of Republican tax policies."

He also notes that:

There are 78,000 tax filers with incomes of $211,000 to $533,000 who will pay no federal income taxes this year. Even more amazingly, there are 24,000 households with incomes of $533,000 to $2.2 million with zero income tax liability, and 3,000 tax filers with incomes above $2.2 million with the same federal income tax liability as most of those with incomes barely above the poverty level.

But, it is the low income households that Republicans complain about, usually something along the lines of:

Those on the right often complain that it is fundamentally undemocratic for such a large percentage of the population to pay nothing to offset the federal government’s general operations. After all, everyone benefits from national military spending and other federal programs.

But why is it better to, say, tax the poor $100 and then given them $120 in benefits instead of just sending $20? Why go to all the trouble and cost of collecting the extra $100 and then giving it back? Unless the real argument is that there should be no redistribution to the poor, i.e. that they should get back less than the $100 they paid, certainly no more, I don't see why it's better. One argument is that you can earmark the $100 for particular types of spending, but that seems like the kind of paternalism the right likes to (say) they avoid. I guess the argument is that somehow this makes people aware of the value of what they receive, but it seems like a weak argument to me.

In any case, this is hard to disagree with:

Perhaps the right and left can at least agree that it is unseemly for those in the top 1 percent of income distribution, with incomes at least 10 times the median income, to pay no federal income taxes. It’s not socialism to ask them to pay something.

It's also reasonable to ask those at the top to pay their fair share, and to participate in the burden of reducing the long-term deficit through tax increases.

An implication of recent research is that "stricter environmental regulation would benefit low-income children in particular":

Born to Lose: Health Inequality at Birth, by Nancy Folbre: In an imaginary world of equal opportunity we would all be free to choose our own economic future. In reality, many children in the United States are born to lose, suffering health disadvantages at birth that reduce their likelihood of economic success.

Epidemiologists and economists have long agreed that low birth weight is an important, albeit approximate, predictor of future health problems. A wealth of new economic research ... shows that it is also an approximate predictor of future earnings problems, with statistical effects almost as strong as children’s test scores. ...

In the current American Economic Review, Janet Currie ... summarizes recent findings and points out that children of black mothers who dropped out of high school are three times as likely as children of white college-educated mothers to suffer low birth weight.

Many of the mechanisms that underlie this inequality are linked to characteristics of the physical environment, such as exposure to environmental toxins. ... Professor Currie’s research shows that black and Latino children are significantly more likely than white children to be born to mothers living in proximity to such hazards, supporting arguments long made by environmental justice advocates. ...

[An] important policy implication is that stricter environmental regulation would benefit low-income children in particular. Professor Currie has taken part in research showing that reductions in the release of three toxicants (cadmium, toluene, and epichlorohydrin) from 1988 to 1999 account for a 3.9 percent reduction in infant mortality over that time. ...

Yet many children in the United States live, play or go to school in areas with dangerously poor air quality...

Professor Currie herself tends to emphasize the pricing problem. As she put it: “Factories dump toxic releases into the atmosphere but don’t pay the cost of pollution. There would be less harm to the children who ingest the toxins if the factories had to bear the cost.”

Changes would happen even more quickly if the chief executives of these companies — and their children — had to bear the cost. But these adults are free to choose where to live and what to breathe. And their children are, for the most part, born to win.

Jim Hamilton analyzes the effects of the International Energy Agency's plans to release 60 million barrels of oil from the strategic reserves held by 28 member countries (the US will contribute about half of this total). I think it would be fair to say he's not impressed with this plan:

...the deed is now done, and the IEA has run an interesting experiment for us in how oil markets function. I would recommend against further SPR sales, regardless of the final outcome of the current effort. The reason is that I see the long-run challenge of meeting the growing demand from the emerging economies as very daunting, and in my mind is the number one reason we're talking about an oil price above $100/barrel in the first place.

A one-time release from the SPR, or even a series of releases until the SPR runs dry, does nothing whatever to address those basic challenges.

It's not clear how much impact this will have on prices, but if prices do drop as a result of the release, some countries may take advantage of the opportunity:

the Chinese might see a temporary drop in prices as an opportunity to add to their own SPR. To the extent that happens, we're getting back to the no-effect scenario

If we had a Strategic Job Reserve to draw upon, or something similar, e.g. an infrastructure bank, that might make a difference. But I don't think this will do much to help.

My guess is that the president is trying to signal that the administration cares about the struggles middle and lower income households face due to the recession and lack of job opportunities. But if that's the goal, there are better ways to go about it. Presently, with the focus on deficit reduction, it's not at all clear that job creation is anywhere near the top of the administration's to do list. Introducing job creation legislation, even if only to force the Republicans to vote it down, would be a much better approach to convincing middle and lower income voters that Democrats do, in fact, care about their troubles and are doing their best to help.

If the government won't hold "senior executives and companies responsible for igniting the subprime meltdown" responsible for criminal wrongdoing, then private lawsuits must be used to try to fill the void:

For decades, the public’s trust in the integrity of U.S. capital markets was a source of economic stability and unparalleled prosperity. To maintain this trust, investors must believe that they compete on a relatively equal playing field and that the laws governing the markets will be strictly enforced. In furtherance of these goals, violators of federal rules face civil penalties from the SEC or criminal prosecution by the DOJ. ...

Now, more than ever, private lawsuits are needed to supplement the existing regulatory structure, both to ensure that shareholders are adequately compensated for their losses and to send a strong message that fraudulent conduct will not be tolerated. Indeed, institutional investors continue to vigorously prosecute suits against the companies and executives at the heart of the mortgage crisis, well after the SEC and DOJ have shuttered their civil and criminal investigations. ...

Wrongdoers Have Largely Escaped Government Penalties

While the SEC has reached several settlements in connection with misconduct related to the financial meltdown, those settlements have been characterized as “cheap,” “hollow,” “bloodless,” and merely “cosmetic,” as noted by Columbia University law professor John C. Coffee in a recent article. Moreover, one of the SEC’s own Commissioners, Luis Aguilar, has recently admitted that the SEC’s penalty guidelines are “seriously flawed” and have “adversely impact[ed]” civil enforcement actions. ...

The DOJ has faced similar criticism for its lack of prosecutions. ...

The ... recent report from the Financial Crisis Inquiry Commission (“FCIC”) makes clear that the mortgage meltdown was an avoidable event born of fraud, as well as of failures in corporate governance and risk management. Significantly, the FCIC explicitly concluded that banks selling mortgage products failed to disclose critical information to investors. ...

Nevertheless, in response to this accumulating evidence, the SEC and the DOJ have remained largely silent. Are large, systemically important institutions and their ilk too big to be threatened with sanctions that approximate the size of the frauds perpetrated against the public? Has “too big to fail” transformed into “too big to challenge?”...

Simply put, without forcing executives to answer for their misconduct, no amount of financial reform will restore public trust in government or the markets.

Regulatory Impediments

While many accuse the SEC and DOJ of being “gun shy” with regard to cases against high profile executives, several commentators note that the SEC and DOJ are significantly underfunded. The funding problem is especially acute at the SEC...

Beyond underfunding, many observers point to the free flow of SEC and DOJ officials between the government and private sector as contributing to lackluster regulatory enforcement. This “revolving door” of personnel fosters “regulatory capture,” which aggravates the conflicts of interest that materialize between regulators and the regulated. ...

Further, to the bewilderment of numerous observers,... the SEC’s general policy going forward to act as “middle man” between the DOJ and Wall Street financiers and to provide potential defendants with information as to whether the DOJ plans to pursue litigation arising from their alleged misconduct—a procedure that critics have described as conflicting with the SEC’s own enforcement manual. Recognizing the inherent conflicts in this practice, Senator Charles Grassley ... explained that “[a]ll the promises of financial regulatory reform ring hollow if the administration is allowing the top enforcement official at the SEC to relay to potential targets of an investigation exactly what the Justice Department has in store for them.” ...

How Institutional Investors are Filling the Void

It has increasingly fallen to institutional investors to hold mortgage lenders, investment banks and other large financial institutions accountable for their role in the mortgage crisis... For example, sophisticated public pension funds are currently prosecuting actions involving billions of dollars of losses against Bank of America, Goldman Sachs, JPMorgan Chase, Lehman Brothers, Bear Stearns, Wachovia, Merrill Lynch, Washington Mutual, Countrywide, Morgan Stanley and Citigroup, among many others. In some instances, litigations have already resulted in significant recoveries for defrauded investors.

Historically, institutional investors have achieved impressive results on behalf of shareholders when compared to government- led suits. Indeed, since 1995, SEC settlements comprise only 5 percent of the monetary recoveries arising from securities frauds, with the remaining 95 percent obtained through private litigation as demonstrated by several examples in the chart at right.

Institutional investors must continue to lead the charge and prosecute fraud to send a strong message that such misconduct will not be tolerated and to guarantee that shareholders are fairly compensated for their losses. ... While originally intended as a supplement to government regulation, recent events demonstrate that institutional investors may now be the entities best positioned to protect investors’ rights. Without such protection, and if Wall Street bankers are permitted to profit from their frauds without a proportionate retributive response, we may be fated to repeat the same economic calamity that has defined our generation.

I don't always agree with Clive Crook, but I do agree with his call for the US to strengthen its automatice stabilizers (as discussed in the link mentioned a few days ago at the bottom of this post):

A fiscal policy fit for the next crisis, by By Clive Crook, Commentary, Financial Times: ...The fiscal response to a recession is partly automatic (lower revenues and higher transfers as the economy shrinks) and partly discretionary (lower tax rates, infrastructure projects, extra help for states and so on). Two factors weaken automatic stabilizers in the US. First, the government is small, so economic fluctuations, other things being equal, move fiscal quantities less. Second, states are subject to balanced-budget rules. Much of the US government has to follow a pro-cyclical fiscal policy – cutting spending and raising taxes – during a recession.

This puts a great burden on discretionary policy. Extra federal stimulus, and plenty of it, is needed just to offset automatic tightening in the states. To supply net discretionary stimulus requires very aggressive action in Washington. It is much to Barack Obama’s credit that he pushed through a big federal stimulus for 2009. ... Nonetheless, severe fiscal tightening in the states would have justified something even bigger.

Unfortunately Mr. Obama lost the battle for public opinion. The country thinks the stimulus has failed – and this could be a lasting reversal for fiscal activism. Discussion now revolves around premature tightening and, equally disturbing, new budget rules to constrain fiscal discretion in future. The government of a country with weak automatic stabilizers is talking about ways to limit its own discretion – as though the current paralysis is not enough. This could be a new calamity in the making. ...

As well as steering clear of that, the US should embrace an explicit goal of strengthening its automatic stabilizers. The aim should be to boost stimulus in downturns and curb it in expansions, with a smaller need for intervention by Congress over the course of the cycle. The less one needs to ask of that broken institution, the better. ...

In this Slate column from 1999, Paul Krugman discusses (and dismisses) the "pain is good" economic argument from the 1920s, and then says "one hears exactly the same argument now." Twelve years later, not much has changed.

This also buttresses an argument I've made recently. Some people argue that the problem with the economy is mostly structural rather than cyclical, and that monetary and fiscal policy can do little to help. I disagree on both counts. I think most of the problem we face today is cyclical, not structural, and to the extent we do face a structural problem it's still important to institute "short-run palliatives" that allow us to "keep the work force employed":

No Pain, No Gain?, by Paul Krugman, Slate, Jan. 15, 1999: Once upon a time there was a densely populated island nation, which, despite its lack of natural resources, had managed through hard work and ingenuity to build itself into one of the world's major industrial powers. But there came a time when the magic stopped working. A brief, overheated boom was followed by a slump that lingered for most of a decade. A country whose name had once been a byword for economic prowess instead became a symbol of faded glory.

Inevitably, a dispute raged over the causes of and cures for the nation's malaise. Many observers attributed the economy's decline to deep structural factors--institutions that failed to adapt to a changing world, missed opportunities to capitalize on new technologies, and general rigidity and lack of flexibility. But a few dissented. While conceding these factors were at work, they insisted that much of the slump had far shallower roots--that it was the avoidable consequence of an excessively conservative monetary policy, one preoccupied with conventional standards of soundness when what the economy really needed was to roll the printing presses.

Needless to say, the "inflationists" were dismissed by mainstream opinion. Adopting their proposals, argued central bankers and finance ministry officials, would undermine confidence and hence worsen the slump. And even if inflationary policies were to give the economy a false flush of artificial health, they would be counterproductive in the long run because they would relax the pressure for fundamental reform. Better to take the bitter medicine now--to let unemployment rise, to force companies to purge themselves of redundant capacity--than to postpone the day of reckoning.

OK, OK, I've used this writing trick before. The previous paragraphs could describe the current debate about Japan. (I myself am, of course, the most notorious advocate of inflation as a cure for Japan's slump.) But they could also describe Great Britain in the 1920s--a point brought home to me by my vacation reading: the second volume of Robert Skidelsky's biography of John Maynard Keynes, which covers the crucial period from 1920 to 1937. (The volume's title, incidentally, is John Maynard Keynes: The Economist as Savior.)

Skidelsky's book, believe it or not, is actually quite absorbing: Although he was an economist, Keynes led an interesting life--though, to tell the truth, what I personally found myself envying was the way he managed to change the world without having to visit quite so much of it. (Imagine being a prominent economist without once experiencing jet lag, or never taking a business trip where you spent more time getting to and from your destination than you spent at it.) And anyone with an interest in the history of economic thought will find the tale of how Keynes gradually, painfully arrived at his ideas--and of how his emerging vision clashed with rival schools of thought--fascinating. (Click here for an example.)

But the part of Skidelsky's book that really resonates with current events concerns the great debate over British monetary policy in the 1920s. Like the United States, Britain experienced an inflationary boom, fed by real estate speculation in particular, immediately following World War I. In both countries this boom was followed by a nasty recession. But whereas the United States soon recovered and experienced a decade of roaring prosperity before the coming of the Great Depression, Britain's slump never really ended. Unemployment, which had averaged something like 4 percent before the war, stubbornly remained above 10 percent. There is an obvious parallel with modern Japan, whose "bubble economy" of the late 1980s burst eight years ago and has never bounced back.

Almost everyone who thought about it agreed that Britain's long-run relative decline as an economic power had much to do with structural weaknesses: an overreliance on traditional industries such as coal and cotton, a class-ridden educational system that still tried to produce gentlemen rather than engineers and managers, a business culture that had failed to make the transition from the family firm to the modern corporation. (Keynes, never one to mince words, wrote that "[t]he hereditary principle in the transmission of wealth and the control of business is the reason why the leadership of the Capitalist cause is weak and stupid. It is too much dominated by third-generation men.") Similarly, everyone who thinks about it agrees that modern Japan has deep structural problems: a failure to move out of traditional heavy industry, an educational system that stresses obedience rather than initiative, a business system that insulates big company managers from market reality.

But need structural problems of this kind lead to high unemployment, as opposed to slow growth? Is recession the price of inefficiency? Keynes didn't think so then, and those of us who think along related lines don't think so now. Recessions, we claim, can and should be fought with short-run palliatives; by all means let us work on our structural problems, but meanwhile let us also keep the work force employed by printing enough money to keep consumers and investors spending.

One objection to that proposal is that it will directly do more harm than good. In the 1920s the great and the good believed that an essential precondition for British recovery was a return to the prewar gold standard--at the prewar parity, that is, making a pound worth $4.86. It was believed that this goal was worth achieving even if it required a substantial fall in wages and prices--that is, general deflation. To ratify the depreciation of the pound that had taken place since 1914 in order to avoid that deflation was clearly irresponsible.

In modern times, of course, it would, on the contrary, seem irresponsible to advocate deflation in the name of a historical monetary benchmark (though Hong Kong is currently following a de facto policy of deflation in order to defend the fixed exchange rate between its currency and the U.S. dollar). But orthodoxy continues to prevail against the logic of economic analysis. In the case of Japan, there is a compelling intellectual case for a recovery strategy based on the deliberate creation of "managed inflation." But the great and the good know that price stability is essential and that inflation is always a bad thing.

What really struck me in Skidelsky's account, however, was the extent to which conventional opinion in the 1920s viewed high unemployment as a good thing, a sign that excesses were being corrected and discipline restored--so that even a successful attempt to reflate the economy would be a mistake. And one hears exactly the same argument now. As one ordinarily sensible Japanese economist said to me, "Your proposal would just allow those guys to keep on doing the same old things, just when the recession is finally bringing about change."

In short, in Japan today--and perhaps in the United States tomorrow--behind many of the arguments about why we can't monetize our way out of a recession lies the belief that pain is good, that it builds a stronger economy. Well, let Keynes have the last word: "It is a grave criticism of our way of managing our economic affairs, that this should seem to anyone like a reasonable proposal."

Almost 14 million people ... were officially counted as unemployed last month. But that’s just the tip of the iceberg. There were almost 9 million part-time workers who wanted, but couldn’t find, full-time jobs; 28 million in jobs they would have quit under normal conditions; and an additional 2.2 million who wanted work but couldn’t find any and dropped out of the labor force.

If the economy could generate jobs at the median wage for even half of these people, national income would grow by more than 10 times the total interest cost of the 2011 deficit (which was less than $40 billion). So anyone who says that reducing the deficit is more urgent than reducing unemployment is saying, in effect, that we should burn hundreds of billions of dollars worth of goods and services in a national bonfire.

We ought to be tackling both problems at once. But in today’s fractious political climate, many promising dual-purpose remedies — like infrastructure investments that would generate large and rapid returns — are called unthinkable...

We need to keep posing hard questions to deficit hawks who argue that we shouldn’t be hiring unemployed workers to maintain our crumbling roads and bridges, even though postponing such projects will make them much more expensive in the future. These projects don’t impoverish our grandchildren. They enrich them.

The important point is that bringing down federal deficits is a long-run problem... But our immediate concern must be getting people back to work.

He also talks about, and favors, a payroll tax as one of the few politically viable options. About that, if we go the payroll tax reduction route, we need to design the policy in a way that protects Social Security financing. Many conservatives will try to make the payroll tax reduction permanent, and then use it to starve the Social Security program. From a previous post:

...for those who want to scale back or eliminate Social Security, this would be seen as an opportunity to starve Social Security of finances, create a crisis, then argue for cutbacks. But there are ways to do this that don't involve cutting the payroll tax per se, so the political optics are different yet amount to the same thing. For example, continue collecting Social Security taxes as before, but give workers a temporary rebate that is clearly designated as temporary, and is independent of Social Security taxes. I'm sure there are better ways to do it, but the point is that we can help workers without interrupting the usual payroll tax flow and putting Social Security at risk.

But back to infrastructure. I can't help but think about all of those people who objected to putting more infrastructure spending into the stimulus package back in late 2008 and the early months of 2009. The argument was that there weren't enough shovel ready projects available. If we tried to do too much of this type of stimulus, the economy would already be recovering by the time we put those projects into place, and it would cause the economy to become overheated.

Of course it turned out that we actually needed to provide sustained stimulus, the forecasts for a quick end to the recession were way off.

Presently, the spending is ending and creating a drag just as the economy is struggling to turn upward. The forecasts for a quick end to the recession were wrong, and a larger, more sustained stimulus effort was needed (as many of us argued at the time). Having additional projects coming online now would have been very helpful to the recovery effort.

However, when infrastructure projects are suggested now as a way to help the unemployed and our crumbling infrastrucutre at the same time, the same voices tell us that the first round of stimulus spending showed there aren't enough shovel ready projects available. There's no way to get these projects going in time to do much good.

The best response to that argument -- besides the fact that they were wrong about this before, there was plenty of time to develop projects, and they are wrong again -- is this graph:

Fed Forecast of the Unemployment Rate

There's plenty of time, plenty of unemployed resources, and interest costs are as low as they'll ever be. And, of course, there's plenty of need for investment in infrastructure so there are large benefits from this type of spending.

I have to say that I am not surprised by this at all...and I think that even without the benefit of hindsight, I would not have been surprised (and indeed, I always believed that the government's response would be inadequate). Why? Because we've never really implemented effective countercyclical policy in the past!

First, take the Fed's ability to construct its "usual firewall" between finance and the real economy. What usual firewall? Can you name a systemic financial crisis in our history that was not followed by a protracted economic slump? I am not sure I can. ... Maybe the LTCM collapse?

Now take the Fed's inability/refusal to stabilize nominal GDP growth after the crisis. At the zero lower bound, Fed action pretty much means QE. And when have we (or any country) ever implemented large-scale QE in the absence of out-and-out deflation? I can't think of any example.

Finally, let's consider the political feasibility of stimulus. Has the United States ever purposefully enacted a large countercyclical fiscal stimulus in the past? There's the New Deal, but as DeLong himself has mentioned, it was actually pretty small beer. Clinton's 1993 stimulus bill died a quiet death by filibuster. In fact, the only real example of fiscal stimulus that I can think of was Reagan's military buildup...but that was hardly sold as a stimulus.

So history would seem to indicate that the U.S. government is not very good at protecting the economy from financial crises or implementing countercyclical policy in really deep or prolonged slumps. I suspect, therefore, that Brad... was an optimist regarding the U.S. political economy. Sad to say, that is something I have never been.

Here's one answer answer to the question in the title. This type of fiscal policy has been politically feasible.

I am not a granola environmentalist, but I do see a lot of inefficient policies out there, and as an economist that’s frustrating. And here’s the thing…

At the moment, the US relies on a variety of subsidies and “performance standards” to reduce greenhouse gas emissions from the transportation sector. On the fuel side, we have ethanol subsidies and the Renewable Fuel Standard, which is an implicit subsidy program. On the vehicle side, we have Corporate Average Fuel Economy Standards, or CAFE standards, which dictate the average fuel economy of an automaker’s annual fleet. The current standard for passenger cars is 30.2 mpg. The standard for light-trucks — a classification that also includes SUVs under 8,500 pounds — is 24.1.

On the electricity side, lawmakers also use the Energy Star program, which was created in the early 1990s, to force appliance makers to create more efficient products. ...

My research shows that performance standards – such as CAFE standards – may be more inefficient than previously thought, and that pricing instruments, such as a gas tax, would likely have a bigger impact on reducing greenhouse gas emissions.

My colleagues and I found that a jump in the price of gas causes a significant change in the kinds of cars that consumers buy and the price they pay for them. A $1 increase in the gasoline price changes the market shares of the most and least fuel-efficient new cars by +20% and -24%, respectively. Changes in gasoline prices also change the relative prices of the most fuel-efficient cars and the least fuel-efficient cars. For new cars, the relative price increase for fuel-efficient cars is $363 for a $1 increase in gas prices; for used cars it is $2839. (For comparison: a $1 increase in gas prices alters the budget of the average household by about $50 a month.)

I am not naïve, and I realize that no politician has ever been elected on a platform of: ‘I’m going to raise your gas prices,’ but by advocating alternatives, they’re promoting inefficient policies that simply hide these inflated costs. There’s a lot of resistance from consumers about the prospect of a gas or carbon tax, but I believe this is mainly because consumers are misled to believe that performance standards are cheaper.

The run-up in the price of gas in recent years has been substantial enough to make top auto executives give up their historic opposition to gasoline price taxes: some have even suggested that Congress should ... create a $4 floor for retail gasoline prices.

Mike Jackson, CEO of AutoNation, the largest U.S. dealership chain, told the Wall Street Journal: “We need more expensive gasoline to change consumer behavior. Otherwise, Americans will continue to favor big vehicles, no matter what kind of fuel-economy standards the government imposes on automakers.”

Four dollars a gallon, he added, ‘is a good start.’ Hear, hear.

* Pain at the Pump: The differential effects of gasoline prices on new and used automobile markets; Meghan R. Busse, Christopher R. Knittel, Florian Zettelmeyer; National Bureau of Economic Research; December 2009

The chance of an increase in the gasoline tax in the present political environment is zero, and that may be overly optimistic.

More generally, it's too bad that market fundamentalists who are also deficit hawks refuse to recognize that corrections of market failures through devices such as a carbon tax will make markets work better and raise revenue at the same time. The fact that these solutions are resisted by so called deficit hawks and market fundamentalists is yet another signal that this is more about ideological objections to the size of government than the deficit or the correction of significant market failures.

The empirical evidence behind the expansionary austerity claims can be challenged, but even if you accept it at face value it doesn't imply the US would benefit from pursuing immediate deficit reduction:

The Joint Economic Committee of Congress held a hearing ... to discuss whether such spending cuts would be contractionary or expansionary ... in the short run. After taking part as a witness..., I conclude that large immediate spending cuts would tend to slow the economy.

The general presumption is that fiscal contraction ... will immediately slow the economy relative to the growth it would have had otherwise. ... But some studies have found that ...[u]nder four conditions, fiscal contractions can be expansionary. But none of these conditions is likely to apply in the United States today.

First, if there is high perceived sovereign default risk... But the United States is currently among the countries with the lowest perceived risk...

Second, it is highly unlikely that short-term spending cuts would directly increase confidence among households or companies... The United States still has a significant “output gap”... Fiscal contractions rarely inspire confidence in such a situation.

Third, if monetary policy becomes more expansionary while fiscal policy contracts... But ...[i]t is unclear that much more monetary policy expansion would be advisable, or possible, in the view of the Fed, even if unemployment increases again — as it might if fiscal contraction involves laying off government workers.

Fourth, tighter fiscal policy and easier monetary policy can, in small, open economies with flexible exchange rates, push down (that is, depreciate) the relative value of the currency — thus increasing exports... But this is unlikely to happen in the United States, in part because other industrialized countries are also undertaking fiscal policy contraction. ...

The available evidence, including international experience, suggests it is very unlikely that the United States could experience an “expansionary fiscal contraction” as a result of short-term cuts in discretionary domestic federal government spending. ...

I believe there is a role for government, e.g. correcting market failures, ensuring basic equity, enforcing laws, providing defense, and equalizing opportunity. Some government is unavoidable. But as much as possible government should stay the hell away. I don't like the recent intrusive trends, and the Obama administration has been a disappointment on this issue:

Free to Search and Seize, by David Shipler, Commentary, NY Times: This spring was a rough season for the Fourth Amendment. The Obama administration petitioned the Supreme Court to allow GPS tracking of vehicles without judicial permission. The Supreme Court ruled that the police could break into a house without a search warrant if, after knocking and announcing themselves, they heard what sounded like evidence being destroyed. Then it refused to see a Fourth Amendment violation where a citizen was jailed for 16 days on the false pretext that he was being held as a material witness to a crime.

In addition, Congress renewed Patriot Act provisions on enhanced surveillance powers until 2015, and the F.B.I. expanded agents’ authority to comb databases, follow people and rummage through their trash even if they are not suspected of a crime.

None of these are landmark decisions. But together they further erode the privilege of privacy that was championed by Congress and the courts in the mid-to-late-20th century...

American history is replete with assaults on liberties that first target foreigners, minorities and those on the political margins, then spread toward the mainstream. The 1917 Espionage Act, for example, was used to prosecute American labor leaders and other critics of the government, and the 1798 Alien Enemies Act was revived after Pearl Harbor to intern American citizens of Japanese ancestry. A similar process is taking place now, as the F.B.I. has begun using counterterrorism tools to search, infiltrate and investigate groups of American peace activists and labor leaders in the Midwest.

The Fourth Amendment is weaker than it was 50 years ago, and this should worry everyone. “Uncontrolled search and seizure is one of the first and most effective weapons in the arsenal of every arbitrary government,” Justice Robert H. Jackson, the former chief United States prosecutor at the Nuremberg trials, wrote in 1949. “Among deprivations of rights, none is so effective in cowing a population, crushing the spirit of the individual and putting terror in every heart.”

In the past, developing countries tended to follow procyclical fiscal policy. They increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession. Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialized countries that has been by and large countercyclical (Gavin and Perotti 1997, Tornell and Lane 1999, Kaminsky et al. 2004, Talvi and Végh 2005, Mendoza and Oviedo 2006, Alesina et al. 2008, and Ilzetski and Végh 2008).

Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle. Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or more. We can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.1

Figure 1 (which is a version of evidence presented in Kaminsky et al. 2004) depicts the correlation between government spending and GDP for 94 countries over the period 1960-1999. More precisely, it shows the correlation between the cyclical components of spending and GDP with the longer-term trends taken out. The set includes 21 developed countries, which are represented by black bars, and 73 developing countries, represented by yellow bars. A positive correlation indicates government spending that is procyclical, i.e. destabilizing. A negative correlation indicates countercyclical spending, that is, stabilizing.

There is no missing the message. Yellow bars lie overwhelmingly on the right-hand side. More than 90% of developing countries show positive correlations (procyclical spending). Black bars dominate the left hand side. Around 80% of industrial countries show negative correlations (countercyclical spending).

Why would policymakers pursue procyclical fiscal policy? One does not have to believe in “fine tuning” to see the undesirability of a pattern under which government response exacerbates the amplitude of the business cycle. The most convincing explanations in the literature entail either imperfect access to credit or political distortions.

The historic shift in cyclicality

Over the last decade there has been a historic shift in the cyclical behavior of fiscal policy in the developing world. Figure 2 updates the statistics, showing the period 2000-2009. The number of yellow bars on the left side of the graph (negative correlations) has greatly increased. Around 35% of developing countries 26 out of 73 now show a countercyclical fiscal policy, more than quadruple the share during the earlier period.

Figure 3 presents a scatter plot with the 1960-1999 correlation on the horizontal axis and the 2000-2009 correlation on the vertical axis. The lower right quadrant shows the graduates from procyclical to countercyclical fiscal policy. The star performers include Chile and Botswana; but 24 developing countries altogether (out of 73) have made this historic shift.

The evidence of countercyclicality among many emerging-market and developing countries matches up with other criteria for judging maturity in the conduct of fiscal policy, such as debt/GDP ratios, rankings by rating agencies, and sovereign spreads. Low income and emerging market countries in the aggregate have achieved debt/GDP levels around 40% of GDP over the last four years. The IMF estimates the 2011 ratio at 43% among emerging market countries and 35% among low-income countries. This is the same period during which debt in advanced countries rose from about 70% of GDP to 102%.

The financial markets have ratified the historic turnaround. Spreads are now lower for many emerging markets than for some “advanced countries.” Rating agencies rank Singapore as more creditworthy than Belgium, Korea ahead of Portugal, Mexico ahead of Iceland, and just about everybody ahead of Greece. Euromoney ranks Chile as less risky than Japan, Korea less risky than Italy, Malaysia less risky than Spain, and Brazil less risky than Portugal.

Largely as a result of their improved fiscal situations during the period 2000-2007, many emerging markets were able to bounce back from the 2008-2009 global financial crisis more quickly than advanced countries (Didier et al. 2011).

How did they do it?

What explains the ability of some countries, particularly emerging-market and developing countries, to escape the trap of procyclical fiscal policy? We believe that the main story concerns institutions.2 In our new research (Frankel et al. 2011), we find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment.

Although one thinks of institutions as slow-moving, they can change over time. Chile’s institutional quality has risen strongly since the early 1980s, during which time its fiscal policy has turned from procyclical to countercyclical. A country with good institutional quality in the general sense of rule of law can help lock in countercyclical fiscal policy through specific budget institutions. Frankel (2011a) explains how Chile did it, with the structural budget reforms of 2000 and 2006. Chile’s approach could be emulated by others.

Fiscal rules, such as the Eurozone’s Stability and Growth Pact, may accomplish little in themselves. Rules can actually worsen the tendency of governments to make overly optimistic forecasts for economic growth and budget balance (Frankel 2011b). Chile’s key innovation was to give responsibility for forecasting to independent expert commissions, insulated from politicians’ wishful thinking.

Even advanced countries have something to learn about countercyclical fiscal policy from Chile and others to the South. Saving during expansions such as 2001 to 2006 is critical for weathering the storm in recessions such as 2008-09. Otherwise there may be no way out but to adjust at the worst possible time.

As lawmakers prepare for the bill’s July 21, 2011 implementation date, House Republicans passed several measures narrowing the scope of the bill, including a measure that would exempt companies that manage up to $50 million in securities from having to register with the Securities and Exchange Commission; a bill exempting most private equity fund advisers from having to register with the SEC; a bill repealing the provision in Dodd-Frank requiring publically-traded companies to disclose their employees’ median compensation separately from their CEO pay packages; and a bill creating a legal framework for the use of covered bonds.

House Financial Services Committee Chairman Spencer Bachus (R-AL) said that all of the bills were designed to create jobs. Reps. David Schweikert (R-AZ), Robert Hurt (R-VA) and Nan Hayworth (R-NY), who introduced three of the provisions, said their bills remove burdensome regulations that are both costly and unnecessary for small businesses.

Throughout the markup, Rep. Barney Frank (D-MA), ranking member of the committee and one of the architects of Dodd-Frank, expressed his frustrations with the various new provisions and made several failed attempts to amend them. When House Republicans said that they were concerned about finding sufficient funding for the SEC to fulfill all of its new regulatory obligations, Frank said that Congress should not scale back regulation because of budgetary limitations, citing the cost of the war in Afghanistan, and saying that the Congress can certainly find the necessary funding for the regulatory agencies. He went on to say that the costs of failing to regulate the financial markets are significantly higher.

Because we failed to regulate banks properly, there are millions of unemployed looking forward to poor job prospects as far as forecasters can see. Yet we hear the argument that "all of the bills were designed to create jobs," i.e. that somehow dereguating the financial sector is the key to job creation. Yeah, right.

FOMC Reaction, by Tim Duy: The two-day FOMC meeting ended largely as expected, with the Fed reaffirming the current policy stance. If you were looking for signs that QE3 is on the horizon, you were sorely disappointed. If anything, the FOMC statement shifted in a slightly hawkish direction, setting the stage for the next policy move to be a tightening. The Fed is trying to make it as straightforward as possible – in the absence of clear and convincing evidence that deflation is again a threat, they have nothing else to offer.

The statement itself made clear the Fed interprets much of the current data flow as reflecting temporary factors, either the impact of higher commodity prices or the disaster in Japan. Interestingly, though, temporary factors alone are not sufficient to explain the slowdown, as the 2012 GDP forecast was downgraded. Federal Reserve Chairman Ben Bernanke admitted this during his subsequent press conference. In response to a request for the forecast he brought to the meeting, he suggested that he was on the low side of expectations:

[The] “slowdown is at least partly temporary….can’t explain the entire slowdown…Growth at least in the near term might be a little bit less than we anticipate.”

Still, despite the slowdown, the Fed removed the “employ its policy tools as necessary to support the economic recovery” language, presumably because they have no intention of providing any additional support. Moreover, inflation trends are no longer “subdued.” Instead, they see a “subdued outlook for inflation,” another signal that they are not thinking about easing, but instead restraining themselves from tightening now.

As Mark Thoma notes, Bernanke made clear that the shift away from deflation concerns effectively ends the possibility of another dose of quantitative easing. So what happened to the Bernanke of a decade ago, when he chastised the Bank of Japan for inaction? Brad DeLong laments:

Those of us Democrats who were happy when Barack Obama reappointed Ben Bernanke as Fed Chair thought that we were getting the Ben Bernanke we knew--the student of the Great Depression and of Japan's Lost Decade dedicated to doing whatever was necessary to stabilize the time path of nominal GDP, up to and including dropping bales of money out of helicopters.

Whatever happened to him?

My first thought is that we forgot or overlooked the fact that Bernanke is a child of the Bush Administration, which should have been a red flag that he was not all that he was thought to be. My second thought is that I don’t see Bernanke as terribly out of line with the current Administration itself. Third, Bernanke made clear in his response to a Japanese reporter that he sees himself as exactly the Bernanke of a decade ago. His comments then meant that:

“…a determined central bank can always do something about deflation.”

Like inflation, deflation is a monetary phenomenon, and, as such is within the control of the monetary authority. He acted on that belief last fall with the Fed’s second large-scale asset program – a policy that had more to do with eliminating deflationary expectations than the path of growth. Those deflationary concerns have now been replaced by the more traditional inflationary concerns. To be sure, the growth forecast leaves much to be desired, and the unemployment outlook should arguably be seen as a crisis. But – and I think this is key – the Fed believes that they have little traction over growth at this juncture. Thus, additional policy yields no improvement on the employment outlook, but potentially adds to an already uncomfortable inflation tradeoff.

Simply put, from the Fed’s point of view, the balance of risks is clear. And that means we should expect nothing more from Constitution Ave.

Despite the clear direction from Bernanke, Bill Gross of PIMCO doubled-down on his failed bet that this statement would hint at QE3. Via Reuters:

Gross, the co-chief investment officer of PIMCO, the world's top bond manager, on Wednesday said on Twitter: "Next Jackson Hole in August will likely hint at QE3 / interest rate caps."

Consider the timeline. Today, the FOMC and Bernanke himself only further distanced themselves from another dose of easing in this cycle. That means he need a full 180 degree turn by August, less than two months away. Consider too that we would need a deflation threat to create such a turnaround. But, even if commodity prices stabilize, or even decline, the pass-through from previous price increases is still likely to be working its way through the core data. And it defies belief that, given the current attitude among FOMC members, they would entertain the thought of deflation with such inflationary pressure in the pipeline, even if you believe it to be temporary pressure.

Moreover, any commodity price declines are likely to provide a boost to growth. Moreover, so too will an easing of Japanese related supply issues. Which means a reasonable chance that growth looks stronger in comparison to recent weakness. Not terrific, mind you, but the level is unimportant. What is important is simply that growth does not deteriorate, and instead improves, however modestly.

All of this argues against Gross’s outlook. Which means you need a vastly contrarian actual outcome, and it needs to fall into place quickly. That outcome, as far as I can see, is some combination of a shift to deflation concerns, a dramatic downward shift in the 2012 growth forecasts, or massive financial contagion from the European crisis (best guess on this is that Europe kicks this can down the road for a few months anyway).

Which, in sum, means to need to ask yourself this question if you are going to jump into the Bill Gross camp: “Do you feel lucky, punk?” It seems like an awful lot needs to go wrong in the next few weeks to get QE3 at Jackson Hole. I am not saying that it can’t go wrong, and if it does I will happily give credit to Gross for his wisdom and insight. That said, the time horizon is remarkably short, and will shrink rapidly, to generate the kind of change of heart at the Fed necessary to prod officials into another round of easing. It would seem that financial crisis is the only event that could prompt such a shift in just two months.

Bottom Line: The Fed believes they are done easing, and policymakers now look toward tightening. I know, I know – they have said this before, which is reason enough to take their tough talk with a grain of salt. But the shift in the inflation outlook looks very much to represent the high water mark for policy. The data will need to dramatically deteriorate to shift the Fed’s focus away from tightening.

Un-Spin the Budget, by Paul Krugman, Commentary, NY Times: ...The Congressional Budget Office suggests in its latest monthly budget review that the deficit in fiscal 2005 will be "significantly less than $350 billion, perhaps below $325 billion." Last year the deficit was $412 billion.

The usual suspects on the right are already declaring victory over the deficit, and proclaiming vindication for the Laffer Curve - the claim that tax cuts pay for themselves, because they have such a miraculous effect on the economy that revenue actually goes up.

But the fact is that revenue remains far lower than anyone would have predicted before the tax cuts began. In January 2001 the budget office forecast revenues of $2.57 trillion in fiscal 2005. Even with the recent increase in receipts, the actual number will be at least $400 billion less.

And nonpartisan budget experts, such as Ed McKelvey of Goldman Sachs, believe that even the limited good news on the budget is a temporary blip, not a turning point. Douglas Holtz-Eakin, the director of the Congressional Budget Office, warns us to take the new revenue figures with a "grain of salt," and declares that "if you take yourself to 2008, 2009 or 2010, that vision is the same today as it was two months ago."

A close look at the tax data explains why these experts believe that we're seeing a temporary uptick in revenues, not a sustained change in the trend. Taxes that are closely tied to the number of jobs and the average wage, such as payroll taxes and income taxes automatically withheld from paychecks, aren't showing any big pickup. This confirms other data showing that the economy as a whole is, if anything, doing worse than one would expect at this stage of an economic recovery.

It turns out that all of the upside surprise in tax receipts is coming from two sources. One is tax payments from corporations, up both because last year corporate profits grew much more rapidly than the rest of the economy and because the effective tax rate on corporations went up when a temporary tax break, introduced in 2002, expired. Both are one-time events.

The other source of increased revenue is nonwithheld income taxes - taxes that aren't deducted from paychecks but are instead paid by people receiving additional, nonsalary income. The bounce in nonwithheld taxes probably reflects mainly capital gains on stocks and real estate, together with bonuses paid in the finance and real estate industries. Again, this revenue boost looks like a temporary blip driven by rising stocks and the housing bubble.

In other words, we're still deep in the fiscal quagmire, with federal revenues far below what's needed to pay for federal programs. And we won't get out of that quagmire until a future president admits that the Bush tax cuts were a mistake, and must be reversed.

I wonder if the "usual subjects" who proclaimed "vindication for the Laffer Curve" would admit now that they were wrong. Doubtful, even though it's abundantly clear they were. Krugman is right that the revenue boost was "a temporary blip driven by rising stocks and the housing bubble."

As for getting out of the "quagmire" when "a future president admits that the Bush tax cuts were a mistake," it turns out admitting it isn't quite enough. Obama has admitted it, but hasn't done anything about it.

We're at the point where courage from the president means finding a definition of tax increases that Republicans can argue aren't really tax increases, and then asking what else Democrats need to give up to strike a deal on immediate job-killing deficit reduction. Instead of taking a chance of killing the recovery and the jobs that come with it, what we need is short-term stimulus and a plan to address long-run budget problems. Short-run stimulus is not going to happen, and about the best we can hope for is that Congress makes immediate cuts that are mostly accounting tricks rather than actual reductions in spending. Given their propensity to do this, perhaps there's some hope along these lines.

As for the longer-run, why not end the Bush tax cuts two years from today (or at some point in the future) for anyone with incomes above a particular threshold? Put it up for a vote tomorrow to see who is actually for deficit reduction. You'd hear the objection that the expectation of future taxes will kill innovation and economic growth today, but if there's evidence for this at all, the effects are relatively minor (and all taxes have costs associated with them, so the question is really which taxes are the most equitable and impose the least burden). That these objections find an audience shows the degree to which the ideas embedded in the Laffer Curve have taken hold.

Update on Bernanke's Press Conference: Bernanke all but ruled out QE3. In response to a question about whether the Fed is considering further easing, Bernanke noted that this is a committee decision, it's not his to make alone, but he gave two main reasons why the Fed is reluctant to pursue additional asset purchases. First, when the Fed decided to put QE2 in place, there were substantial worries about deflation. Thus, the Fed was missing both elements of its dual mandate by a wide margin, and further easing would help to increase inflation and stimulate output. Now, however, although the output gap is still large, the Fed is starting to see signs of inflation. Bernanke stated that most people underestimate the negative impact inflation can have on growth and employment, and this indicates the Fed will not be willing to increase the risks that inflation will become a problem.

The other reason he gave for being wary of further easing is that the Fed is starting to increases in wages. Thus, the Fed is worried about an emerging wage-price spiral, and it is determined to stop this from happening. A wage-price spiral was a big problem in the 1970s and the beginning of the 1980s, and memories of this episode make the Fed unlikely to do anything that might cause it to happen again.

In the past, Bernanke has also stated that the Fed is in unfamiliar territory with the inflated balance sheet from QE1 and QE2, and that creates a lot of uncertainty about how much inflation risk the Fed has created. This also works against further easing.

Finally, in his presentation of the Committee's forecasts of where the economy is headed, Bernanke noted that most committee members expect relatively strong output growth next year, and that is another reason why the committee is thinking more about when to begin tightening than it is about further easing.

There were many questions about this, i.e. when the Fed might begin tightening policy, but Bernanke was very careful not to tip his hand. He said it will depend on how the recovery progresses, but as noted above most Committee members expect relatively strong growth next year.

If the economy weakens considerably, anything is possible, but there's no indication at this time that the Fed has any inclination toward further easing.

One more thing. As I've said a couple of times recently, I think it's a mistake for the Fed to look past the current slowdown in the recovery (it should ask itself how often it has had to downgrade its forecasts in the past). This is a critical point in the recovery, and if the Fed makes the wrong choice, it could make things worse than they need to be. I didn't expect to hear news of further easing at this meeting, but I did hope to hear a bit more willingness to consider it.

Gender Values: The Costs of War, by Susan Feiner: At ten years and counting, the wars in Iraq and Afghanistan are the longest in U.S. history. Not surprisingly, they are the most expensive, with total war spending poised to top two trillion dollars early this summer. ... The U.S. government's spent over $2,000 per capita on all aspects and accouterments of war. ...

Spending on the military counts for a huge share -- 58 percent -- of U.S. discretionary federal spending. If military funding were redirected to meet critically important social needs, the nation as a whole would reap enormous benefits. ...[gives examples]

This military spending has yet another negative economic impact, and that's on the labor market. The largest share of military spending goes to weapons procurement, not to pay soldiers or other military personnel. The consequence of this is that it closes off employment opportunities in fields where women are most likely to earn decent salaries.

Dollars spent on the military and dollars spent on domestic programs like health care and education call very different jobs into existence. According to an important study by the Political Economy Research Institute (PERI),... one billion dollars spent on education or health care would create many more jobs than does spending the same amount on military projects. When the nation spends one billion dollars on the military, 11,600 jobs are created. If that billion dollars was spent instead on education 29,100 jobs would be created. And if it were spent on health care almost 20,000 jobs would be created. The military currently rips through more than $600 billion per year. If ... $300 billion were spent instead on education and health care, the employment picture would shift dramatically. The sum of $150 billion spent on education would create over four million jobs. Spending another $150 billion on health care would create about three million jobs. Adding the two sets of new jobs together, and subtracting out the military jobs that are lost, yields 3.8 million new jobs,... driving the unemployment rate to down from the current level of nine percent to under seven percent.

The positive benefits of such a change for women can't be understated. ...

The quarterly data goes back to 1990, and it's good to put the last few years in context. I've scaled all the series by price (the consumption spending deflator) and population. Here is the net worth series:

There's been talk of a Japan-like 'lost decade' in the US; that seems optimistic. US real per capita net worth is back to what it was back in 1999.

The US problem is on the assets side:

The effect of the recent recession on assets in Canada is similar to that of the demise of the dot-com boom.

Aggregate household liabilities have also fallen in the US, but as can be seen in the net worth data, not by enough:

Few will be surprised to learn that the collapse of US house prices had an important effect on US asset holdings:

Although the fall in US housing assets was more dramatic, other assets lost value as well:

And lastly (although if someone can think of another interesting graph, I may add it), here is real per capita housing equity:

The US data go back to 1952, so I was able to check the last time the real, per capita value of US housing equity was at its current level. Even after looking at all of these graphs, the answer astonished me: 1978. Nineteen seventy-freaking-eight.

Obama could use recess appointments for Elizabeth Warren, Peter Diamond, and others, but it might make Republicans mad. Can't have that, can we? It might get in the way of plans to cooperate with Republicans to undermine the recovery with job-killing deficit reduction, and to impose spending cuts on important social programs.

No, that's not a typo. House Speaker John Boehner and other Republicans regularly rail against "job-killing government spending." ... Using the same illogic, employment should soar if we made massive cuts in public spending—as some are advocating right now.

Acting on such a belief would imperil a still-shaky economy that is not generating nearly enough jobs. So let's ask: How, exactly, could more government spending "kill jobs"? ...

The generic conservative view that government is "too big" in some abstract sense leads to a strong predisposition against spending. OK. But the question remains: How can the government destroy jobs by either hiring people directly or buying things from private companies? For example, how is it that public purchases of computers destroy jobs but private purchases of computers create them? ...

Despite ... evidence and logic, some people still claim that fiscal stimulus won't create jobs. Spending cuts, they insist, are the route to higher employment. And ideas have consequences. One possibly frightening consequence is that our limping economy might have one of its two crutches—fiscal policy—kicked out from under it in an orgy of premature expenditure cutting. Given the current jobs emergency, that would be tragic. ...

Keynes’ General Theory is 75 years old. In this column, Paul Krugman argues that many of its insights and lessons are still relevant today, but many have been forgotten. A broad swath of macroeconomists and policymakers are applying old fallacies to today’s crisis. As the nostrums being applied by the “pain caucus” are visibly failing, Keynesian ideas may yet make a comeback.

And the article:

Mr. Keynes and the Moderns, by Paul Krugman: It’s a great honor to be asked to give this talk, especially because I’m arguably not qualified to do so.[1] I am, after all, not a Keynes scholar, nor any kind of serious intellectual historian. Nor have I spent most of my career doing macroeconomics. Until the late 1990s my contributions to that field were limited to international issues; although I kept up with macro research, I avoided getting into the frontline theoretical and empirical disputes. By contrast I probably do have a better sense than most technically competent economists of the arguments that actually drive political discourse and policy. And this discourse currently involves many of the same issues Keynes grappled with 75 years ago. We are – frustratingly – retracing much of the same ground covered in the 1930s. The Treasury view is back; liquidationism is once again in full flower. We’re having to relearn the seeming paradox of liquidity-preference versus loanable-funds models of interest rates.

What I want to do in this lecture is talk first, briefly, about how to read Keynes – or rather about how I like to read him. I’ll talk next about what Keynes accomplished in The General Theory, and how some current disputes recapitulate old arguments that Keynes actually settled. I’ll follow with a discussion of some crucial aspects of our situation now – and arguably our situation 75 years ago – that are not in the General Theory, or at least barely mentioned. And finally, I’ll reflect on the troubled path that has led us to forget so much of what Keynes taught us.

On reading Keynes

What did Keynes really intend to be the key message of the General Theory? My answer is, that’s a question for the biographers and the intellectual historians. I won’t quite say I don’t care, but it’s surely not the most important thing. There’s an old story about a museum visitor who examined a portrait of George Washington and asked a guard whether he really looked like that. The guard answered, “That’s the way he looks now.” That’s more or less how I feel about Keynes. What matters is what we make of Keynes, not what he “really” meant.

I’d divide Keynes readers into two types: Chapter 12ers and Book 1ers. Chapter 12 is, of course, the wonderful, brilliant chapter on long-term expectations, with its acute observations on investor psychology, its analogies to beauty contests, and more. Its essential message is that investment decisions must be made in the face of radical uncertainty to which there is no rational answer, and that the conventions men use to pretend that they know what they are doing are subject to occasional drastic revisions, giving rise to economic instability. What Chapter 12ers insist is that this is the real message of Keynes, that all those who have invoked the great man’s name on behalf of quasi-equilibrium models that push this insight into the background – from John Hicks to Paul Samuelson to Mike Woodford – have violated his true legacy.

Part 1ers, by contrast, see Keynesian economics as being essentially about the refutation of Say’s Law – the possibility of a general shortfall in demand. And they generally find it easiest to think about demand failures in terms of quasi-equilibrium models in which some things, including wages and the state of long-term expectations in Keynes’s sense, are held fixed while others adjust toward a conditional equilibrium of sorts. They draw inspiration from Keynes’s exposition of the principle of effective demand in Chapter 3, which is, indeed, stated as a quasi-equilibrium concept: “The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand”.

So who’s right about how to read the General Theory? Keynes himself weighed in, in his 1937 QJE article (Keynes 1937), and in effect declared himself a Chapter12er. But so what? Keynes was a great man, but only a man, and our goal now is not to be faithful to his original intentions, but rather to enlist his help in dealing with the world as best we can.

For what it’s worth, I’m basically a Part 1er, with a lot of Chapters 13 and 14 in there too, of which more shortly. Chapter 12 is a wonderful read, and a very useful check on the common tendency of economists to assume that markets are sensible and rational. But what I’m always looking for in economics is ‘intuition pumps’ – ways to think about an economic situation that let you get beyond wordplay and prejudice, that seem to grant some deeper insight. And quasi-equilibrium stories are powerful intuition pumps, in a way that deep thoughts about fundamental uncertainty are not. The trick, always, is not to take your equilibrium stories too seriously, to understand that they’re aids to insight, not Truths; given that, I don’t believe that there’s anything wrong with using equilibrium analysis.

And as it turns out, Keynes-as-equilibrium-theorist – whether or not that’s the “real” Keynes – has a lot to teach us to this day. The struggle to liberate ourselves from Say’s Law, to refute the “Treasury view” and all that, may have seemed like ancient history not long ago, but now that we’re faced with an economic scene reminiscent of the 1930s and we’re having to fight those intellectual battles all over again. And the distinction between loanable funds and liquidity preference theories of the rate of interest – or, rather, the ability to see how both can be true at once, and the implications of that insight – seem to have been utterly forgotten by a large fraction of economists and those commenting on economics.

Old fallacies in new battles

When you read dismissals of Keynes by economists who don’t get what he was all about – which means many of our colleagues – you fairly often hear his contribution minimized as amounting to no more than the notion that wages are sticky, so that fluctuations in nominal demand affect real output. Here’s Robert Barro (2009): “John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall.”And if that’s all that it was about, the General Theory would have been no big deal.

But of course, it wasn’t just about that. Keynes’s critique of the classical economists was that they had failed to grasp how everything changes when you allow for the fact that output may be demand-constrained. They mistook accounting identities for causal relationships, believing in particular that because spending must equal income, supply creates its own demand and desired savings are automatically invested. And they had a theory of interest that thought solely in terms of the supply and demand for funds, failing to realize that savings in particular depend on the level of income, and that once you take this into account you need something else – liquidity preference – to complete the story.

I know that there’s dispute about whether Keynes was fair in characterizing the classical economists in this way. But I’m inclined to believe that he was right. Why? Because you can see modern economists and economic commentators who don’t know their Keynes falling into the very same fallacies.

There’s no way for me to make this point without citing specific examples, which means naming names. So, on the first point, here’s Chicago’s John Cochrane (2009):

When Welling ran into one of her old bosses at a bookstore, he asked how she was doing and then told her in no uncertain terms that she was a fool for going public about the backdated stock options.

As Welling put it, he "started saying how stupid I was to have objected to the backdating. He said everybody knew that was how large cases were worked at the IRS -- that audit decisions were political decisions that were made at the top and that everyone went along. He said that was just how big business and government operate all the time." And then, Welling said, her old boss told her, in the context of the Madoff Ponzi scheme that went undetected despite warnings, that "financial statements given to the SEC are filled with lies."

Other IRS managers I have spoken to over the years about Welling and other whistleblowers have made similar, although far less blunt, assessments. ...

That the IRS was made aware of backdating and did nothing remains scandalous. So is the lack of congressional inquiry into how the IRS knew about the backdated stock options and, except for Welling, looked the other way.

How are we going to raise sufficient money to finance our government if the cynical attitude that organizations can lie with impunity on their disclosure statements and tax returns pervades tax law enforcement? And why would anyone do what Welling did if the result is to be fired, threatened with having your CPA credentials pulled, and threatened with prosecution? ...

Get It Over With, by Dani Rodrik: When Argentina defaulted on its debt a decade ago, the country became a pariah in the eyes of foreign bankers and bondholders and was shut off from international financial markets. Yet its economy recovered quickly and experienced rapid growth thanks to a large boost in external competitiveness provided by a vastly depreciated currency. The lesson is that default can be the better option when the alternative is years of continued austerity.

In the case of Greece, this scenario is greatly complicated by the country’s membership in the euro zone. Greece would have to exit the euro zone to be able to engineer a currency depreciation. Since this is something for which euro zone rules do not make any allowance, a unilateral exit will unleash huge uncertainty about the rules of the game. And a Greek default will almost certainly be considered a hostile act by Greece’s European partners – never mind that German and other euro zone banks were equally at fault for having over-lent to the Greek government.

Unfortunately, the current strategy seems destined to force Greece to this outcome. It is predicated on protecting German and other European creditors and bondholders while Greek workers, retirees and taxpayer pay the bill. This makes no sense economically, and will not work politically.

One way or another, Germany, France and other euro zone creditor countries are on the hook. If Greece eventually defaults, they will have to pay for their banks’ mistakes. It would be far better for them -- and for the future of the euro zone -- if this reality were recognized quickly. A coordinated, agreed-upon reworking of the rules will not be easy. But it will do less damage than insisting on politically unsustainable levels of austerity and having default and exit from the euro zone forced on the Greek government by protests on the streets.